Buddy, Just Hand Over That Dime

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Neither a borrower nor a lender be, but if you have to choose, be a corporate debtor. America’s mortgage banks may now be discovering the dangers of reckless loan-writing. But other lenders are still chasing corporate debt like greyhounds after a rabbit.

Despite the subprime meltdown, creditors have not seriously restricted the amount they are willing to lend to companies or much increased the interest rates they demand. According to Standard & Poor’s (S&P), a rating agency, $46.5 billion of European bonds and loans had been brought to market by the end of February, only a shade less than the $48.3 billion raised in the same period of 2006.

Meanwhile, Moody’s, its rival, says the spread (or excess interest rate) on high-yield corporate credit has risen by only around a third of a percentage point from its February 22nd low and is still below its 12-month average. Given that government-bond yields have fallen over the same period, it seems unlikely that most companies are paying any more to borrow money than they were a month ago, before the American mortgage crisis started to generate adverse headlines.

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Indeed, there are plenty of signs that borrowers are the masters, not the servants, in this relationship. TDC, a Danish telecoms group, recently announced it was cutting the interest rate it agreed to pay to lenders just 12 months ago. And Europe is now seeing the introduction of “covenant-lite” loans, which offer little protection to lenders if the borrower’s financial position deteriorates.

In America, such loans account for 23 percent of the market by volume so far this year, according to S&P. And Neal Schweitzer of Moody’s says even second-lien loans (which give a lesser claim to a company’s assets than prior loans) are increasingly covenant-lite.

Lenders have traditionally insisted on covenants so they can get their money back before disaster strikes. They might, for example, insist that interest payments should not rise above a certain proportion of the firm’s earnings; breach of the covenant would require renegotiation or repayment of the debt.

Companies understandably do their best to avoid such undertakings. Covenants can severely reduce a group’s flexibility, forcing it to come up with extra money when its financial position is weakening. In some cases, they can trigger a collapse.

The first European covenant-lite deal was arranged for a Dutch yellow-pages publisher, VNU World Directories, a company backed by two private-equity groups. Private-equity houses, well aware that times are good at the moment, are keen to lock in the most flexible financing arrangements they can. The last thing they want is for a covenant to be triggered at some future date, requiring them to take a hit to their equity investment.

But why should lenders grant such flexibility? Some may reckon that covenants are no longer necessary. First, they can now sell loans in the secondary market, an option that did not exist 20 years ago. Second, as TDC showed, borrowers can simply refinance their deals if they no longer like them. A covenant may thus be as much use as a chocolate teapot.

A further reason may be the nature of the investor. The biggest buyers of high-yield (or leveraged) loans tend to be the managers of collateralised loan obligations, or CLOs. Such managers bundle together a group of loans, then slice them up, according to their riskiness, and sell them to investors. Once a CLO manager has raised its capital, it needs to put that money to work quickly to earn higher interest. That makes the manager an eager loan-buyer, forced to accept whatever terms the borrowers offer.

Loan securitisation disperses risk through the financial system and reduces the chances of a banking collapse. But it does have its downside, as has already been seen with American mortgages. In the old days, a bank was stuck with its loans and needed to worry about the long-term creditworthiness of the borrower. Nowadays, a bank will pocket an underwriting fee and get the loan off its books within weeks. In their eagerness to get deals done, argues Paul Watters of S&P, banks and investors do not differentiate sufficiently between good deals and bad.

Investors are naturally blasé because they have suffered so few problems in the debt markets in recent years. Defaults have been remarkably rare. With the interest rate on safe havens such as Treasury bonds at low levels, there has been plenty of incentive to take risks. But the credit cycle will turn eventually. When it does, investors, unprotected by covenants, may be left feeling wallet-lite.